1.2.7 Price Mechanism

Question 1

State and explain the three Functions of the Price Mechanism?

Answer 1

1. Rationing Function: Prices act as a rationing mechanism to allocate scarce resources among competing uses.
   When demand exceeds supply, prices rise, discouraging some consumers from buying, and ensuring that goods are allocated to those willing to pay the highest prices. Example: During a natural disaster, like a hurricane, there may be a shortage of essential supplies like bottled water. As prices rise due to increased demand, those in urgent need may be willing to pay more, while others may reduce their consumption, allowing resources to go where they are most needed.
2. Incentive Function: Prices provide incentives for producers to allocate resources efficiently.
   Higher prices indicate increased demand, motivating producers to produce more of a particular good or service. The incentive is higher profit.
   Lower prices signal decreased demand, encouraging producers to reallocate resources to more profitable uses. Example: If the price of crude oil rises significantly, oil-producing countries have a greater incentive to increase production as they can earn higher revenues. This can lead to increased oil supply in the market. The incentive is to minimise losses.
3. Signalling Function: Prices convey information about changing market conditions, allowing consumers and producers to make informed decisions. Rising prices may signal potential shortages, prompting consumers to conserve and producers to increase supply. Falling prices may indicate oversupply, prompting consumers to buy more and producers to cut back on production.

Question 2

How does the price mechanism work in different markets? (How are prices determined?)

Answer 2

1. Local Markets: In local markets, prices are determined by supply and demand conditions within a specific geographic area. Local factors, such as weather or local preferences, can influence prices. Example: The price of fresh produce at a local farmers’ market may vary based on seasonal factors and local supply.
2. National Markets: National markets cover an entire country and consider supply and demand at a broader scale. National policies and regulations, such as taxes and trade policies, can impact prices. Example: The national housing market may be influenced by government policies related to interest rates and mortgage regulations.
3. Global Markets: Global markets involve international trade and can be influenced by factors like currency exchange rates, global supply chains, and geopolitical events. Prices in global markets are interconnected and can impact local and national markets. Example: The price of oil in global markets affects fuel prices around the world, impacting consumers and industries in various countries.

Question 3

Why is it important for the price mechanism to shift the market in equilibrium?

Answer 3

To allocate resources efficiently at equilibrium. This minimises deadweight losses, surpluses, shortages. This helps the market achieve allocative efficiency.